The adoption tax credit – What’s the catch?

There are three “catches.” They involve timing, qualifying, and post-filing activity.

By: Alison Flores  /  March 21, 2016

Taxpayers sometimes think the adoption credit is too good to be true.

That’s partially because of the credit’s high dollar amount. For instance, in 2016, adoptive parents who claim the adoption tax credit can receive a maximum credit of $13,460 per child.

Some documentation rules also surprise taxpayers. For example, parents who adopt a child with special needs can claim the full credit even if they didn’t have expenses, and they do not need to document the expenses they did incur.

So, is there a catch?

There’s not just one catch, but several. The biggest catches for the adoption credit revolve around timing and qualifying for the credit. After that, some adoptive parents who claim the adoption credit receive an IRS notice, and some may experience delayed refunds.

The first catch: It’s not always clear when to claim the credit

An adoption can take years to complete. Adoptive parents often incur adoption expenses long before and after the adoption.

For the adoption credit, qualified adoption expenses can include:

  • Adoption fees
  • Court costs
  • Attorney fees
  • Traveling expenses (including meals and lodging)
  • Expenses to re-adopt (under state law) a foreign child who was adopted abroad
  • Other expenses directly related to, and whose principal purpose is for, the legal adoption of an eligible child

Qualified adoption expenses do not include costs for adopting a step-child.

Determining when to claim the credit can be tricky

The good news is, taxpayers can use all qualified adoption expenses to claim a credit. The tricky part is determining which year to claim the credit for those expenses. And the rules are different for domestic and foreign adoptions.

The charts below summarize these rules, which are unique in the tax realm. That’s because, usually, taxpayers must claim expenses for the tax year in which the taxpayers incurred the expenses. For the adoption credit, it’s more complicated.

Domestic adoptions
If the adoptive parent pays qualifying expenses in: Claim the credit in:
Any year before the year the adoption becomes final The year after the year of the payment
The year the adoption becomes final The year the adoption becomes final
Any year after the year the adoption becomes final The year of payment

 

Foreign adoptions
If the adoptive parent pays qualifying expenses in: Claim the credit in:
Any year before the year the adoption becomes final The year the adoption becomes final
The year the adoption becomes final The year the adoption becomes final
Any year after the year the adoption becomes final The year of payment

 

For domestic adoptions, adoptive parents can claim a credit before the adoption is final, and they can even claim the credit for failed adoptions.

Other surprises? For domestic or foreign adoptions, parents can claim an adoption credit:

  • Without claiming the child as a dependent on their tax returns
  • Before they know the child’s Social Security Number

Because of the time it often takes to complete an adoption, adoptive parents should understand the timing rules so they don’t miss out on their full adoption credit. If taxpayers need to change a past return, the normal rules apply: Taxpayers generally have three years from the original due date of the return to file an amendment and claim a refund.

The adoption credit can be carried forward to future tax years

Many adoptive parents find that their tax liability for the year they finalize the adoption is lower than their allowable adoption credit. That means they can’t take full advantage of the credit in the year they finalize the adoption. This happens for several reasons.

Taxpayers with children often claim other credits, such as the child care credit and education credits. These credits, combined with increased personal exemptions and other deductions, often reduce taxpayers’ tax balances. Other taxpayers find that their wage income is lower during the year of adoption, often because they take extra time off work to complete the adoption. Lower wages can also lower their tax liabilities.

Taxpayers who don’t fully use the adoption credit in the year they claim it can carry forward the unused portion of the credit for up to five years. To take advantage of the carryforward benefit, taxpayers must file Form 8839, Qualified Adoption Expenses, to claim the adoption credit in the original year. In each subsequent year, they can use the carryforward.

There’s an extra advantage to stretching the credit over five years:  When taxpayers claim the adoption credit along with other tax credits on their return, the adoption credit is applied after other nonrefundable credits. This allows taxpayers to benefit from other credits during the year they claim the adoption credit, and in the carryforward years.

Adoptive parents who didn’t claim the adoption credit in the first year they were allowed to claim it can amend the past return to claim the credit and carry it forward to an open year. This works even if it has been more than three years since the first year they were allowed to claim the credit. However, taxpayers must adjust the carryforward amount to account for any credit that they could have claimed in the first year and in subsequent years.

The second catch: Qualifying for the credit isn’t always obvious

“You keep using that word. I do not think it means what you think it means.” Inigo Montoya, “The Princess Bride”

Many words in the tax code require special and specific definitions that govern the outcome. That’s no different when it comes to the adoption credit. Here, misunderstanding could mean the difference between claiming a $13,460 credit and receiving an IRS notice assessing tax, interest and penalties.

Define “special needs”

In a special needs adoption, a state or government agency may pay some or all of the adoption expenses. However, adoptive parents can still claim the maximum adoption credit for a special needs adoption, even if they have no actual cash outlay for the adoption.

For adoption credit purposes, a child is considered a special needs child if:

  • The child is a citizen or resident of the United States (including U.S. possessions),
  • A state (including the District of Columbia) determines that the child cannot or should not be returned to his or her parents’ home, and
  • The state determines that the child probably will not be adopted unless the state or other government agency provides adoption assistance to the adoptive parents.

States use several factors to determine whether a child has special needs, including:

  • The child's ethnic background,
  • The child's age,
  • Whether the child is a member of a minority or sibling group, or
  • Whether the child has a medical condition or physical, mental, or emotional disability.

The law strictly spells out that a state or governmental body must determine that a child has special needs before the child could be considered to have special needs under the law. A 2014 unpublished decision* in federal district court interpreted this requirement to mean the state must make an individualized decision about each prospectively adopted child.

Taxpayers adopting a special needs child should keep a copy of the state determination of special needs. A taxpayer who can’t prove that an adoption was a state-defined special needs adoption will be allowed to claim the adoption credit only for actual expenses paid, rather than the maximum amount.

Define “final”

It’s not always easy for taxpayers to determine the exact moment when a foreign adoption becomes final. For foreign adoptions, this determination is critical because parents typically incur many expenses, and they can’t claim the adoption credit until the year they finalize the adoption.

Often, parents adopt children abroad and then re-adopt them in the U.S. under state law. Sometimes parents are required to re-adopt, and sometimes parents just choose to re-adopt. These parents may not be sure whether the year of the foreign adoption or the domestic adoption would be key for claiming the adoption credit. And for any child adopted abroad, parents may wonder what event causes the adoption to be treated as final.

The IRS provides two sets of safe harbors for determining the year an adoption is finalized, depending on whether the adoption is governed by the Hague Adoption Convention.

View a summary of the safe harbors.

The third catch: The IRS may send letters or delay refunds

Adoptive parents should be prepared in case they receive IRS correspondence about their adoption credit claim. For example, the IRS might send correspondence saying that it is holding all or a portion of the tax refund until the IRS receives specific information about the adoption. It’s important to respond to IRS correspondence as soon as possible by mailing or faxing the requested information to the IRS address or fax number shown on the notice.

Parents should keep the following records:

  • Receipts for qualified adoption expenses
  • Canceled checks
  • Bank statements
  • Entry visas for foreign adoptions
  • Final decrees
  • Certificate or order of adoption
  • Home study by an authorized placement agency
  • Child placement agreements or court orders
  • Determination of special needs status by a state, the District of Columbia, or U.S. possession

In case the IRS questions how taxpayers calculated the adoption credit carryforward, parents should keep tax returns for the original and subsequent years.

Prepare for the process

Adoptive parents have a lot to navigate before, during, and after an adoption, and they will receive advice from adoption agencies, nonprofits, state agencies, and attorneys along the way.

In the middle of it all, the adoption credit can make a big difference for adoptive parents. Knowing about potential snags can help parents successfully integrate the tax-filing process into their own adoption stories.

 

* Lahmeyer v. United States, No. 13-23288-CIV-ALTONAGA/O'Sullivan, 2014 U.S. Dist. LEXIS 114896 (S.D. Fla. Jul. 25, 2014).

Share
Author Name

Alison Flores

Alison Flores, JD, is a principal tax research analyst at The Tax Institute. Alison specializes in the Patient Protection and Affordable Care Act, same-sex marriage, tax preparer regulation, and individual income tax issues.

Homepage

Connect with H&R Block